A Model of R&D Valuation and the Design of Research Incentives

We develop a real options model of Ramp;D valuation that takes into account the uncertainty in the quality (or efficacy) of the research output, the time and cost to completion, and the market demand for the Ramp;D output. The model is then applied to study the problem of pharmaceutical under-investment in Ramp;D for vaccines to treat diseases affecting the developing regions of the world. To address this issue, world organizations and private foundations are willing to sponsor vaccine Ramp;D, but there is no consensus on how to administer the sponsorship effectively. Different research incentive contracts are examined using our valuation model. Their effectiveness is measured in the following five dimensions: expected cost to the sponsor, probability of development success, consumer surplus generated, expected number of successful vaccinations and expected cost per person successfully vaccinated. We find that, in general, purchase commitment plans (pull subsidies) are more effective than cost subsidy plans (push subsidies). Moreover, we find that a hybrid subsidy plan constructed from a purchase commitment combined with a sponsor research cost-sharing subsidy is the most effective